William C Krafve v. Minister of National Revenue, [1984] CTC 2021, 84 DTC 1002

Goetz, TCJ:—This appeal was heard by me in Calgary, Alberta on September 23 and 24, 1982, in my capacity as a member of the Tax Review Board but this judgment is being rendered in my present capacity as a judge of the Tax Court of Canada.

This is an appeal with respect to the appellant’s 1978 taxation year. In effecting the assessment for the 1978 taxation year, the respondent assumed, inter alia :

3. . . .

(a) the shares of Site Oil Tools Ltd were gifted to the Krafve Family Children’s Trust, and were specifically not sold to the Trust.

(b) Site Oil Tools Ltd and the Krafve Family Children’s Trust are residents of Canada.

(c) the fair market value of the shares on July 20, 1978 was at least $7,560 per share.

At the outset of the hearing counsel for the appellant agreed that the shares of the appellant in Site Oil Tools Ltd were gifted to the Krafve Family Children’s Trust and that Site Oil Tools Ltd and Krafve Family Children’s Trust are residents of Canada. The appellant, however, disagreed with the valuation placed on the shares by the respondent, claiming that they were worth no more than $3,500 per share.

Facts

Site Oil Tools Ltd (“Site Tools”) was a small company engaged in the marketing of tools for construction and completion of oil and gas wells. The appellant was an American citizen residing in Canada and doing consulting work in the oil geological field. The appellant acquired shares in 1972 in trust for a family company known as LLano Oil & Gas and later, on June 10, 1976, purchased shares of Site Tools at $2,500 per share. On October 15, 1976, he sold five of these shares at $2,500 per share. It was he and another shareholder who each bought five shares to be held in trust for a Mr Stafinski. The negotiations for the price of the share occurred some time prior to 1976.

It was the desire of the appellant to use Site Tools as a marketing company in Canada. Site Tools did not have sufficient capital to expand and Krafve was able to obtain exclusive rights from various US suppliers to market their tools in Western Canada. This situation obtained between 1973 and 1977. The appellant’s time was spent in financing the company and managing the financial affairs as well as giving personal guarantees for borrowed capital as required by the Bank. The shares were ultimately distributed as follows:

The company had been operated by Bill Jani and James Ross who conducted the day-to-day business of the company. Bill Jani was considered an expert in the oil tool business and Ross was the actual marketing agent. Stafinski also provided loans of capital and guarantees to Site Tools. Stafinski and the appellant returned to the United States in 1976 because they could not agree with the way the company was being operated and over-extending itself financially. This created ill relations between the two operating shareholders (Jani and Ross) as opposed to Stafinski and Krafve (the appellant). After their departure, Site Tools sent guarantees to the appellant in the United States which the appellant refused to sign. Krafve Family Children’s Trust was created on or about July 20, 1978 when the appellant gifted his 30 shares to the Trust for and on behalf of his children who resided in the United States of America.

The appellant filed the financial statements of Site Tools for the years 1973 to 1977 inclusive and also an interim financial statement for the nine months ending September 30, 1978. The latter financial statement is not of great significance in my deliberation but it does indicate a slight downturn of the business which, apparently, is somewhat cyclical but the business began to revive in 1979. The appellant indicated that he had felt, in July 1978, that the company was in a precarious position because of an increase of possibly close to 400 per cent in the cost of tools as inventory, but sales were up only 15 per cent. In 1978 the company’s bankers wanted to put the company into receivership. After the gifting of his 30 shares, the appellant consulted an accountant who indicated that the company must cut down its increased costs because of declining sales. Following this advice, costs were reduced and the financial position of the company improved in 1979. It was in that year that there was an upswing in the oil business and the sales grew and, at that point in time, the family trust sold all its shares at $6,900 per share in an arm’s-length transaction.

The appellant also filed shareholders’ salaries and bonus schedules of Site Oil Tools Ltd hereinafter set forth:

It clearly indicates what the shareholders received by way of salary and bonuses in the 1976 and 1977 taxation years. This money was paid out to the shareholders so it could be deducted as an expense by the company as opposed to a distribution of dividends. This was the wish of Jani. The appellant’s $58,800 bonus paid to him in 1977 was treated as a loan by the company and the company paid tax thereon and the appellant repaid his loan when the Children’s Trust sold the shares in 1979. It is interesting to note that the appellant came to Canada in 1967 and returned to the United States of America in 1976.

J M Stafinski was a petroleum engineer who purchased shares in Site Tools in 1974. Stafinski stated that the 1978 financial year would not have been so bad had they not spent so much money expanding. In November of that year he loaned the company $45,000. He, like Krafve, provided the financial backing and guarantees to the banks. He unfortunately put his shares up for sale in 1979, but has been unable to find a willing purchaser because potential buyers are afraid of the minority share position that now exists and more so of the personality of Jani who is, apparently, a very aggressive and opinionated man although he has excellent expertise in oil field tool equipment. Stafinski communted between Texas and Calgary once a week in order to deal with Site Tools. In 1976 he loaned the company $22,800 and, in 1977, a further sum of $39,200.

Findings

The appellant’s first argument rested on Article VIII of the Canada-US Tax Convention which reads as follows:

Art VIII. Gains derived in one of the contracting States from the sale or exchange of capital assets by a resident or a corporation or other entity of the other contracting State shall be exempt from taxation in the former State, provided such resident or corporation or other entity has no permanent establishment in the former State.

The key words of this Article are “. . . sale or exchange of capital assets”. When the Canada-US Tax Convention was signed, the Canadian Income Tax Act did not read the same then as it was changed in 1971. Counsel for the appellant relied on paragraph 69(l)(b) of the Act which reads:

69. (1) Except as expressly otherwise provided in this Act,

(b) where a taxpayer has disposed of anything

(i) to a person with whom he was not dealing at arm’s length for no proceeds or for proceeds less than the fair market value thereof at the time he so disposed of it, or.

(ii) to any person by way of gift inter vivos, he shall be deemed to have received

proceeds of disposition therefor equal to that fair market value;

He argued therefore that the gift was a deemed disposition. I cannot agree with this position and find that “sale” or the words “sale or exchange of capital assets” means just that. They do not include the word “gift” or “acquisition”. A gift is a conferred benefit. See The Queen v Edmund Littler, [1978] CTC 235; 78 DTC 6179, a decision of the Federal Court of Appeal wherein the Chief Justice, at 239 and 6181 respectively, stated:

. . . in my view, the word gift in a taxing statute must be taken as referring to what is known to the law as a gift, namely, the gratuitous transfer of property and the difference between value and price is not “property” and is not something that can be transferred.

See also Holbrook R Davis v The Queen, [1978] CTC 536; 78 DTC 6374. In this case Décary, J of the Federal Court — Trial Division, considered Article VIII of the Canada-US Tax Convention and stated at 538 and 6375 respectively:

I cannot concur with the view expressed by learned counsel for Plaintiff to the effect that the deemed to be disposition is a sale or exchange. A deemed to be disposition is a fiction created by the statute for a specific purpose and herein only for what is known as the departure tax, whereas in my opinion, the reference to sale and exchange in article VIII of the Convention means sale and exchange as they take place in the course of events and not as a fiction created by statute. Furthermore, it cannot be said that a gain is derived from a deemed to be disposition.

The words “disposition” or “alienation” were not used in Article VIII of that Convention.

As a matter of fact, counsel for the appellant argued that it was open to the Board (as it then was) to find that the shares were worth no more than $2,400 at the time of gifting to the Children’s Trust and, therefore the Tax Convention between Canada and the United States was irrelevant. I simply say that the Convention between Canada and the United States is not relevant for the reasons expressed above.

It is therefore incumbent upon me to reach a conclusion as to the market value of the shares when they were gifted on July 20, 1978 to the Krafve Family Children’s Trust Fund. Both the appellant and the respondent adduced evidence with respect to the value fo the shares as of that date through their appraisers.

The appellant called W Peter Comber as his evaluation witness and the respondent called W J Stabbier as his evaluator. Both witnesses were well qualified as was conceded by both counsel. Although their evaluation reports were replete with various approaches to making their respective evaluations, they both, in the final resort, used “the earning approach” method.

Comber states “that the fair market value of the minority share interest held by Mr Krafve in Site Tools lay in the range of $3,400 to $4,000 at the valuation date”. Stabbler, on the other hand, stated in his report: “In our opinion the fair market value as at July 20, 1978 of the shares fell in a range of $7,560 to $8,820 per share”.

Krafve was the beneficial owner of 30 per cent of the outstanding shares as can be noted from the share distribution hereinbefore referred to. Comber ascertains representative earnings as shown in Table 3 of his report. His valuation summary is as follows:

Valuation Summary — In summary, under the capitalization of earnings approach the following value results from the foregoing earnings and multiplier analysis:

Representative earnings	$85,000
Capitalization rate (15% after tax return)	6.67
Capitalized value (corporate)	566,950
Per share	5,670
25% discount	1,675
Value of 30% interest	3,995
Rounded	$ 4,000

Stabbler, on the other hand, makes his calculations as follows:

(See Appendix I)

In summary, Stabbier states:

In summary:

Fair Market Value at July 20, 1978					LOW		HIGH
(a) of all shares of the company viewed “en bl oc”					$8 10,000 — $91 30,000
(b) rateable value per share					$ 8,400 — $ 9,800
(c) of shares owned by Mr Krafve (being rat eable
values per share less a 10% discount)					$ 7,560 — $ 8,820
		APPENDIX I
		Site Oil Tools Ltd
Calculation of Maintainable After Tax Earnings
		1973	1974	1975		1976	1976	1977		1977
Net earnings before income tax
per financial statements		$49,166	$ 60,400	$ 52,745		$	164,282	$	157,391
Add: Non-recurring expense —
Salaries drawn by
shareholders				105,000			196,000
Adjusted net earnings before
income tax		49,166	60,400	52,745			269,282		353,391
Weight factor		1	2		3		4			5
		$49,166	$120,800	$158,235		$1,077,128		$1,766,955
Total								$3,051,484
+ 15 (sum of weight factors) —
weighted average									$203,432
Less income taxes	5342 @ 50%						26,716
	150000 @25%						37,500			64,216
Income after Tax									$139,216
Therefore indicated maintain
able after tax earnings of (say)									$140,000

The marked difference in evaluations comes about on the basis of two factors:

1. A minority shareholder interest;

2. Whether or not the bonuses paid Krafve in 1976 and 1977 were a non-recurring expense.

Comber, in his report, would discount the shares by at least 25 per cent, whereas Stabbier would discount them by 10 per cent. At the hearing Comber stated that the discount could go up to 50 per cent. Both appraisers admitted that their discount figures were a matter of subjective decision. An informed and willing purchaser would readily observe the dramatic increase in earnings between 1973 and 1977 by perusing the financial statements of Site Tools. Stabbier, in evidence, felt that the discount could run between 15 and 20 per cent. It was suggested that Jani and Ross were the company and that, if they left, the company would fail — hence a prospective purchaser of shares would look for a minority discount. The fact that the franchises obtained by Krafve were in place in the company must not be forgotten. A discount of 25 per cent for minority shares seems more realistic and I so find. Stabbier indicated that the general evaluation procedures take the highest of the values ascertained from existing assets Or earnings.

The company in 1976 and 1977 had acquired a dramatic surplus which was distributed by way of bonuses on a basis very close to the holdings of the respective shareholders. Dividends could have been declared as opposed to the granting of bonuses. For tax reasons the bonus route was taken. The basic difference between the two evaluations is that Stabbier dealt with the bonuses in 1976 and 1977 as non-recurring expenses. It must be remembered that Krafve and Sta- finski were the major financial contributors to the company and would wait for remuneration until the company was in a solid financial position as it was in 1976 and 1977 — hence the distribution of surplus earnings in those years. In 1976 Krafve ceased participating in the company’s activities on his return to the United States. The bonuses then took on the colour of a non-recurring expense. In 1979 shares sold for $6,900 a share.

The increase in value from July 20, 1978 to December 1979 is ample proof for me that Comber’s evaluation was far too low. I there-fore accept Stabbier’s evaluation of the shares as opposed to Comber’s. The appeal is therefore allowed in part and the matter referred back to the Minister for reconsideration and reassessment according to my findings.

Appeal allowed in part.